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Construction of a Theoretical Silver Trade

If you have read my Investment Methodology you might want to understand a little more about my process for setting up trades with asymmetrical risk/reward characteristics. Below is a simplified explanation of an theoretical silver trade. Basically, I try to identify trades in which every $1 of capital I risk is offset by several dollars worth of upside potential.

From my methodology you will know that two of the primary risks of this approach are:

(i) The view is wrong, either through misunderstanding the market situation or not appreciating that the
    market has already discounted the view taken.

(ii) The timing is wrong and the position reaches its risk tolerance limit before the anticipated market action
     occurs.

So how might I reduce the risk of failure and losses?

A Theoretical Silver Trade

Taking silver as an example, following my analysis I may conclude that silver is significantly undervalued and that there is a strong likelihood of higher silver prices in the years ahead. Before I can purchase silver however, I have to be sure that the potential return significantly outweighs any potential risks.

(1) Lets say that my primary reason for wishing to purchase silver is the dwindling level of above ground inventory. From my research I may know that silver inventories have shrunk dramatically from 10 billion ounces in 1940 to the 600 million or so today. So only 6% of the 1940 inventories remain. The decrease has been driven by a dramatic increase in the use of silver for industrial applications, such as components for laptops, mobile phones, CDs etc. We will never get that silver back and in my view it places a floor under the price of silver – as inventories dwindle, the price will rise.

(2) But what if I am wrong? I need further comfort in order for me to enter a trade. From my research I also know that the silver market is tiny. The 600 million ounce stockpile is worth less than $8 billion at the time WhichWayGold was launched. So one billionaire could buy the entire investment stockpile. The tiny size of the market further supports my investment view of higher silver prices in the future.

(3) However, risks still remain. Perhaps my view that prices will rise is correct but they take 50 years to do so, making it a poor choice of investment. Is there anything which helps me time the trade? My research identified three factors which provide comfort that prices will start rising sooner rather than later.

(3a) Firstly, commodities have been out of favour as investments for some time now. The internet boom kept people focussed on dot.com stocks, then came the turn of property. Since there was little interest in commodity stocks the sector suffered a period of underinvestment. Few new mines were commissioned and production levels dwindled. As a result, supplies of commodities, including silver, have decreased and the supply of silver coming onto the market each year will likely not be sufficient to meet demand, especially if the proportion of investors moving into silver increases.

(3b) Secondly, in reaction to the global economic crisis, governments around the world have showered the globe with money. At some point, as recovery nears, this money will begin to flow into the economy and will ignite inflation. As the inflation accelerates, people holding depreciating paper assets will rush into hard, tangible assets such as silver, increasing demand significantly and pushing the price of silver up dramatically.

(3c) Finally, if I am wrong that we will see hyperinflation it means that the governments managed to successfully contain the crisis. In this case the global economy will resume its pattern of growth, increasing the demand for industrial materials, electronic equipment etc and therefore silver. In this case, even if my view that silver will be used as a safe haven is incorrect, the price of silver will still rise as the economy picks up and inventories dwindle.

Conclusion

So here I have one investment idea to buy silver. I have multiple factors which could lead to significantly higher prices and multiple factors which put a floor under the current silver price.

a) The inventory of above ground silver is dwindling
b) The silver market is so small that it could be bought by one billionaire - it seems nonsensical that a
    material used so widely in industry could be so cheap when stockpiles are running out
c) The mining sector has suffered from underinvestment and supply is unlikely to keep up with demand
d) Excess money printing by world governments will lead to hyperinflation and investors will rush to silver as
    a store of value
e) If I am wrong and there is no hyperinflation, the economy will recover, leading to further demand for silver in
    industry

Based on the above I have my desired asymmetric risk/reward profile and begin to drip-feed money into the silver market in anticipation of higher prices in the years ahead. If I am correct I could see substantial returns. If I am incorrect my risk should be limited to only a portion of my initial investment.

 

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